Dividend Investing Basics, Advantages, and Disadvantages

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One of the more popular investment strategies is to invest in dividend-paying stocks. In this article, we will go over the basics about what are dividend stocks and the advantages and disadvantages of dividend investing. Dividend investing is a powerful method to grow your wealth while generating regular income. Depending on your financial situation, you can either use the dividend income to reinvest for faster wealth accumulation or use it as a secondary income source to cover your daily living expenses.

Dividend Investing

Dividend investing is basically investing in individual stocks or funds that focus on high dividend stocks. The S&P 500 has an average dividend yield of about 1.9%, e.g., SPY has a yield of 1.85% and VOO has a yield of 1.99%; so when we talk about dividend investing, we are focusing on stocks and funds that have an average yield above the 2% mark.

Is Dividend Investing Superior?

I do not think Dividend Investing is superior to other strategies.

Inherently, a dividend-paying stock performs exactly like a normal stock. For example, if Stock A and Stock B are worth $10 each. Stock A pays its investors 50 cents in dividend and the share price drops to $9.50, while Stock B share price does not change. Both stocks are still worth the same, the only difference is Stock A is now 95% in equity and 5% in cash.

Psychologically, I think dividend investing is more engaging than other strategies. It is fun to see your monthly or quarterly dividend payments grow over time. It is also engaging to be able to reinvest the dividend payments back into more dividend-paying stocks. I think this higher level of engagement helps dividend investors become more proactive about saving money and building their portfolios, thus resulting in a higher success level than typical investors.

Why Do Companies Pay Dividends?

Dividends are basically a way of sharing the profits. Companies take a portion of their profits and give it to their shareholders. Corporations know that this will keep their shareholders happy, helping to retain them and keep them invested in their company.

Not all companies pay dividends as it is not a requirement. Often, older corporations will issue dividends in order to show off their stability. They know that some investors only practice dividend investing, and want to attract their long-term investment in the company.

For example, Disney is a company that has been around for a while that doesn’t necessarily have the kind of growth as a brand new company. Because of this, you won’t make a lot in capital gains from pure growth — at least not like back during their high-growth days. But at the same time, they make a consistent profit and can afford to give a nice dividend to their shareholders.

Usually, once a company starts paying dividends, they try to continue to do so regularly. If a company that normally pays $1 per share per quarter suddenly stops paying dividends after years of consistently paying them, that’s usually not a good sign for the company — it’s often a sign that their ability to provide shareholder profits has decreased for some reason.

Occasionally this might happen if they instead decide to reinvest in the company for growth. In this case, following the company will allow you to have a heads up in these circumstances.

Dividend and Key Information

A dividend is a payment that a company pays to its shareholders. The amount of dividend and the timing of the payments are decided by the company. For example, if you own 100 shares in Home Depot (HD) and they pay $1.36 per share in dividends per quarter (as of 8/23/2019), meaning that you will earn $136 per quarter.

Dividend Investing Basics, Advantages, and Disadvantages 2

Let’s take a look at the Seeking Alpha Dividend Scorecard for the Home Depot above and go through each field.

Dividend Yield

The dividend yield is a percentage number that is the Annual Dividend Payout divided by the current Share Price. For example:

Dividend Yield = Annual Dividend Payout ÷ Share Price

Dividend Yield = $5.44 ÷ $221.02 = 0.0246 = 2.46%

Dividend investors often use the dividend yield as one of the main screening criteria when picking dividend stocks. It is important to note here that the dividend yield is not a fixed number, it changes with the stock price. For example, if the Home Depot share price drops by 50% to $110.51, the yield would double to 4.92%.

Annual Dividend Payout

The annual dividend payout, or Dividend Per Share (DPS), is the amount of money in dollar amount per share that the company is paying to its shareholders as dividends. For example, Home Depot is paying its shareholders $5.44 per share.

Payout Ratio

The payout ratio is the percentage of the company’s earnings paid out to its shareholders as dividends. For example:

Payout Ratio = Dividend Per Share (DPS) ÷ Earnings Per Share (EPS)

Payout Ratio = $5.44 ÷ $11.03 = 0.4931 = 49.31%

This number is more tricky than it first appears. You might see the payout ratio reported as different numbers from different sources because there is no consensus on the period (e.g., do you use the annual numbers or quarterly numbers, or should you use the last 4-quarter numbers or the year-to-date numbers?) or the number you use for earnings (e.g., actual vs estimate earnings, earnings adjustments, etc.).

The main thing to remember is the payout ratio measures the financial health of the company. Basically, if the payout ratio is approaching 100%, the company is paying out most of its profit and not keeping any money for growth-oriented activities like research & development, expansion, acquisition, etc. If the payout ratio is above 100%, the company is digging into its cash reserve to pay shareholders. This is indicative of a short-term profitability issue or the company is writing off some major expenses.

To make sure you have an apple-to-apple comparison when you do your analysis, make sure you standardize how you calculate the payout ratio.

5-Year Growth Rate and Dividend Growth

These two data points show how much the company has been raising the dividend and how long they have been doing it. This is another good indicator of the company’s financial health and stability. The more they can grow the dividends and the longer they have been doing it, the more profitable and stable.

These numbers are especially important to investors who employ the Dividend Growth Investing strategy, where investors exclusively invest in stocks that have raised their dividend payments for X period of time. With this strategy, investors will remove a stock from the portfolio if the company reduces its dividend.

If an S&P 500 company raises the dividend payments consistently for over 25 years, they may have a chance of joining the exclusive club of the Dividend Aristocrats.

Important Dividend Dates

Dividend Investing Basics, Advantages, and Disadvantages 3

Declaration Date

The declaration date, or the announcement date, is the day the company announces the amount of dividend, the ex-dividend date, the record date, and the payout date. The dividend must be declared and approved by the Board of Directors each time they are paid.

Ex-Dividend Date

The ex-dividend date is the most important of the four dates because only shareholders who own the stock prior to the ex-dividend date are eligible for the dividend payment. If you buy shares on the ex-dividend date or after, you’re not eligible for the current dividend payment. However, you can sell your shares on the ex-dividend date or after and still receive the dividend payment on the payment date.

Also, the share price drops by the same amount as the dividend payment on the ex-dividend date.

Record Date

The record date is the day on which a company reviews its records to determine who its shareholders are — only shareholders of record are entitled to the dividend payment. Since stock trades settle two business days after the transaction date and the ex-dividend date is one business day before the record date, an investor must buy the shares before the ex-dividend date to be eligible.

In the example above, 9/3/2019 is the last day to purchase Home Depot shares and get paid $1.36 on 9/19/2019.

Payment Date

This is the date the dividend will be deposited to the shareholder’s account.

Seven Advantages of Dividend Investing

1. Income

The number one advantage of dividend investing is its ability to provide regular income.

Companies that pay high dividends are favorites among investors who are interested in regular income. For example, retirees can use the income from their dividend-paying investments to cover expenses, instead of selling shares when they need cash. Of course, you don’t have to be retired to enjoy the benefits of dividend investing — the principles of passive income is the same for everyone.

2. Compound Growth through Dividend Reinvesting

Another great advantage of dividend investing is the ability to reinvest dividends. Reinvesting dividends means you are taking the dividend payments and using them to buy more shares in the company. By reinvesting the dividends, you can buy more shares which in turn help you earn even more dividends. This is compound growth in action!

3. Two Ways to Grow

Unlike some investments which rely solely on capital appreciation to gain value, dividend-paying stocks and funds also create value through dividend payments. This makes them relatively safer investments since they continue to generate value through dividend payments even if the assets don’t appreciate in market value.

As a dividend investor, you can also look at the average dividend payment per month or per quarter as an ongoing tracking metric to see if you’re growing your portfolio. You should use this metric together with the traditional metric of portfolio value, and not exclusively.

4. More Stable and Less Volatility

Dividend-paying companies tend to be mature, proven, and profitable businesses. They tend to attract long-term, buy-and-hold investors that are looking for consistent income. These two factors combined result in less volatility and more stability than the general Stock Market.

Additionally, dividend payments are much more stable than share price and capital gains. While dividend payments can be cut by companies that are in trouble, it is a rare thing and most companies do everything possible to avoid a dividend cut.

5. Resilient in Bad Market

When the market starts to take a turn for the worse, investors tend to move their money from more volatile investments to income-producing investments like bonds. Since dividend-paying stocks are income-producing investments, they are more attractive in down markets.

Secondly, as the share price drops, the dividend yield increases. As the dividend yield increases, investors will be attracted to the higher yield and this extra demand helps stabilize the share price.

6. Inflation Hedge

Dividend payments historically tend to increase along with inflation, making it an inflation-protected income. In an inflationary environment, businesses pass on the costs to their end consumers which results in a comparable growth of revenues and profits. This allows companies to continue to increase the dividend payment along with inflation.

7. Buy Low Mindset

When you’re focused on share price, you will tend to avoid some stocks because of a falling share price. Assuming a company has good fundamentals, you will be much more likely to buy shares at very depressed prices (which is when you should buy them) when you focus on dividend yield.

When it comes to long-term, cash flow focused investing, share price fluctuation is secondary. Your mindset will be focused on locking in higher yields for years to come by buying stocks low.

Five Disadvantages of Dividend Investing

1. Lower Growth Rate

Since high-dividend stocks tend to be more mature companies, and they are distributing a good percentage of their earnings to shareholders instead of reinvesting into the company, they tend to be slower growth than the general Stock Market.

If you notice, many of the high-flying stocks tend to pay little or no dividend, e.g., Amazon and Facebook, are high-growth companies that do not pay a dividend.

2. Lack of Diversification

When you focus on dividend-paying stocks, you’re naturally cutting out a big chunk of the Stock Market. For example, using Stocks Research Tool on my M1 Finance account as a proxy, you can see stocks that pay 3% or more yield is a small subset comprising of only 23.0% of the total.

Total2%+ Yield% of Total3%+ Yield% of Total
Basic Materials2487630.6%5421.8%
Communication Services813037.0%2328.4%
Consumer Cyclical52014628.1%10720.6%
Consumer Defensive1775329.9%3318.6%
Financial Services1,11439235.2%25122.5%
Real Estate24820984.3%18173.0%

Also, these high-dividend stocks tend to be heavily concentrated in Real Estate, Energy, and Utilities Sectors; and very few are in the Healthcare and Technology Sectors.

3. Tax Efficiency

Unless you are investing specifically for the income, dividend investing is less tax-efficient in two ways if you use this strategy in taxable accounts.

First, dividend payments are taxed at either the qualified income tax rates (same as long-term capital gains tax rates), or at your ordinary income tax rates. This means that even if you reinvest 100% of the dividends into purchasing more shares, you’re still paying taxes each year on the income. This is less efficient than investing in growth companies that directly reinvest their earnings into the company.

Second, dividend income can count against your ordinary taxable income. For investors that are trying to manage their tax bracket, these payments could push them into the next bracket. For retirees that are trying to stay in the 0% long-term capital gains tax bracket, this could be a big deal.

4. Dividend Cut

Although most companies try to pay the same or higher dividend each year, some could run into financial trouble or change direction with regard to dividend payments. When you employ dividend investing, you have to be on the lookout for changes to the dividend payments and the business. So this strategy does take more work than some other investing strategies.

5. More Expensive

Besides taxes, dividend reinvesting could generate additional trading costs. You can largely avoid this by using free trading platforms like M1 Finance or Robinhood; or by investing in a brokerage with an automatic reinvestment plan.

Secondly, ETFs and funds that employ a dividend investing strategy tend to be more expensive than their counterparts. For example:

Bottom Line

When it comes to long term investing, dividend investing helps you focus more on cash flow. Instead of trying to build up the overall balance of your investment account, focus on building up the monthly or quarterly income of your portfolio. By tracking the income growth of your portfolio, you can also make projections on if and when you can live off your investment income.

For an example dividend portfolio, check out the Dogs of the Dow, a portfolio that attempts to invest in the highest-yielding Dow components each year. This is a great starting point for new investors.

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Dividend Investing Basics, Advantages, and Disadvantages

by Pinyo Bhulipongsanon time to read: 10 min
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